Crude Oil and the Dollar: A Marriage of Convenience

After a sustained period apart, crude oil and the dollar are trading together again. Understanding market dynamics impacting the US dollar can be a useful tool for explaining sudden moves in the price of crude that don’t appear to be physically driven. When fundamentals are tight, either due to low supply or high demand, the inverse relationship between the dollar and crude tends to be stronger. However, during periods of oversupply this relationship weakens dramatically as moves in the dollar are unable to overcome the dragging effect of too much supply.

Adding another layer of complexity, the relationship regularly waxes and wanes throughout the course of a year as fundamental drivers evolve. The sporadic nature of the relationship, and its tertiary status as a price driver make the dollar a much more useful tool for explaining what has happened than what will happen. This is an important role though, as it is important to know when sudden sharp moves in crude have been caused by the dollar or when further fundamental or technical investigation is warranted.

Monitoring the dollar is also important when looking at the macro operating environment for crude oil companies. As can be seen in the chart below, the magnitude of the change in crude oil prices is impacted by the currency used. While USD Brent is half of what it was in June 2014, ruble-denominated prices are down only 18%. Those countries that are able to sell their crude oil in dollars but pay their bills in local currency often have an operational advantage versus US based countries that buy and sell in dollars and have therefore been more resilient during the downturn.

Starting in 2014 the relationship between crude and the dollar deteriorated as the realities of global oversupply finally bit into crude prices. There was a brief period at the start of 2015, when hopes were high that re-balancing was imminent that the relationship appeared again. However, these hopes were soon dashed by physical realities, and the inverse relationship between crude and the dollar has been weak since then. Lately though, the relationship has been improving, another sign that global crude fundamentals are steadily improving. Unlike in the false-start of 2015, the relationship has only slowly been strengthening, crude and product inventories around the world have been drawing, crude production out of OPEC is moderated, and US production is not roaring back; these factors all provide fundamental support to the USD and crude’s relationship. As can be seen in the chart below the coefficient of determination (R-squared) plummeted in 2014, but has been steadily rising this year.

Tracking the strength of this relationship is important for explaining unexpected moves in crude pricing, and for identifying periods of time when strong moves in the dollar may have an out-sized impact. As sentiment surrounding the state of global supply has slowly improved, traders await confirmation that demand forecasts are being met. While markets await these fundamental reassurances, there are fewer external drivers for crude pricing. These “pricing doldrums” present an opportunity for sudden sharp moves in oil caused by the dollar. While these moves generally self-correct they can still wreak havoc on sentiment. Understanding the most likely drivers of pricing on any given day is a necessity for being able to tell the difference between a turning point in the market or just more noise.

So What Does This Mean for Crude?

So far this year, weakness in the DXY has been a contributing factor supporting crude prices. However, Federal Reserve Chair Janet Yellen’s recent announcement that the Fed would raise interest rates one more time in 2017 and three more times in 2018 could cause further strengthening. While we do not think the dollar will strengthen enough to actively suppress crude prices, given fundamental factors at play, a stronger dollar removes a leg of support from crude, and could cause any downside movement to be exacerbated.

When talking about the “dollar” in this context, we are referring to the US dollar index (DXY), the DXY is a measure of the value of the dollar against a basket of foreign trading partners’ currencies.